Are ESOPs the new debts?

A celebrity billionaire famously said that he draws very little salary and almost all his earnings come from stock options. The year, 2021 and the first half of 2022 saw many professionals switching gears from companies that offer high cash and variable components as compensations to the ones that offered stock options to their employees. The lure of stock options was even higher in US companies where the start-up ecosystem is much more robust and mature. It’s a unique way to attract high skilled talent who are willing to defer gratification and make it big in the long run. Although the market slump in 2022 has rendered many of these stock options out-of-the money, one should not be cynical of the advantages these instruments have to keep the management motivated and productive. 

What’s worth pondering is the impact of doling out these options on the company’s financial health and on those investors who stake their wealth in the company’s future. Unlike Wall Street and the companies in the financial space that lured employees with high commission for their performance, Silicon Valley and the tech sector has been instrumental in popularizing these options. This is largely attributed to the method through which most of the start-ups and tech firms raise funds through venture capital, instead of through debts and operating cash flows. In a typical bull market company valuations and stock prices stay higher and thus companies need to issue lesser volume of shares to their employees, however, in a bear market the same amount needs to be committed by issuing higher number of shares. Let us try to understand the issue with a simple example, 

Company A issues shares worth 30 Lakhs to employee X during his joining, at a time when each of its shares were valued at Rs 1000, and for Rs 30 lakhs worth of share, company A needs to issue, 3000 shares. Fast forward a year later, in a market slump when company A hires employee Y and offers 30 lakhs worth of shares at a market price of Rs. 500, it will need to issue 6000 shares to employee B. This essentially dilutes the holdings of existing shareholders including employee A. There is nothing questionable about this phenomenon and this is how the stuff works. However, the reason these were never questioned was because of a multi-year bull run where valuations kept going up. In a bear market what companies are doing to mitigate this dilution, is to roll out large share buy-back programs and coming up with new accounting metrics to groom their earnings and cash flow statements. 

The consequences of these buybacks can be dangerous, if employees have stock options, they will generally exit only when their valuations are significantly higher than the price at which they received it and the same would ensure long term commitment towards the company. With share buy-back programs essentially the employees and the management get a new exit route. Many employees of companies in food delivery, consumer-tech, fintech and buy-now-pay later space, where profits have remained elusive despite decade long operations, would seriously consider exercising these buybacks.

When we look at this paradox the mandate for these companies is quite clear. Companies need to have boards that are not mere rubber stamps and exercise due diligence in interest of its shareholders. The hiring spree witnessed in the boom years were largely in the marketing and commercial space. Fancy designations like growth hackers, growth evangelists and digital futurists featured in the LinkedIn profile of professionals, who were essentially involved in nothing more than sales and marketing using digital tools. The insane pressure to scale and deliver a humongous growth put any discussions on operating efficiencies and profitability to the backburner, and the boards largely complied with the management’s decision.  The paradigm of capitalism shifted from a unidimensional pursuit for profit to a unidimensional pursuit for growth in revenue. 

To change the gears towards profitability, requires having people with a completely different mindset and is bound to create friction in the company’s culture. Highly innovative companies like Figma will always have a way out, however, companies that essentially harped on scaling through digital channels to sustain their financing and have now stopped growing, will need to be prepared for a major shakeup or will be rendered structurally unprofitable. 

Thunderbolt is a great weapon for Indra and Zeus to wield, but foot-soldiers wielding thunderbolt is a rare sight. In the same vein, when an instrument that was initially conceived for senior management, is diluted down to cater to the mass market of employees, it results in unforeseen consequences for the company’s and market’s health. There are many things beyond ESOPs to keep the workforce happier. Many organizations have rechristened their HR divisions as People and Organization and have come up with employee centric offerings that creates long term commitment beyond stock options and fosters a healthy culture where growth, profitability and sustainability can co-exist. While sustainability discussions have largely brought the giant corporations under the lens, ESG is not only about environment, but the S also strongly alludes to social well-being of employees and the G is a mandate for transparent governance. Unfortunately, the hype around this seminal concept has largely been used to raise capital instead of driving adoption towards a new model of capitalism. 

We live in an attention economy, where companies make headlines when they offer insane packages or else, when they fire employees. Rarely do we get to know about corporations offering long term career grooming; assistance for terminal illness and facilitating education for children. Corporations and market rarely step in to correct their own ills until forced by regulations, the dot com bust was followed by Sarbanes-Oxley and the 2008-GFC saw Dodd-Frank regulations. The principle of these regulations was emulated globally with regional flavours. Only time will tell the course of regulations to address the systemic risk that has been posed existing market conditions. The cataclysm of ESOPs and growth hacking would require a serious re-evaluation. 

Dwaipayan Chakraborty is a business consultant with EY-Global and an alumnus of IIM Shillong. 

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